fear and greed index

What is the Fear and Greed Index?

deltafx writer 14 August 2021

CNNMoney created the fear and greed index to gauge the main two emotions affecting the amount of money that traders are willing to pay for different stocks. This index is measured based on four time frames which include daily, weekly, monthly and yearly. Investors use this index to see if the stock market has fair prices. The developers of this index believe that excessive fear will decrease the price of stocks, and a high level of greed has an opposite impact and will increase the price of stocks.

How does the fear and greed index work?

As we already said, investors use this index as a tool to gauge the market. The developers of this index believe that it works based on the logic that extreme fear will lead to trading stocks much below their real value; however, the consequence of extreme greed will be trading the stocks at a much higher value than they are worth. Some pessimistic investors do not accept this index as reasonable because they think it supports a market timing strategy rather than a buying-and-holding strategy.

The fear and greed index uses seven different factors to measure the amount of fear and greed in the market. These seven factors are:

  1. Market volatility: the use of the Chicago Board Options Exchange’s Volatility Index by CNN which is focused on a 50-day moving average.
  2. Stock price momentum: the value of the S&P500 index against the 125-day moving average
  3. Stock price strength: the comparison of the volume of stocks hitting 52-week highs against the volume of stocks hitting 52-week lows in the New York Stock Exchange
  4. Junk bond demand: evaluating the investors’ willingness for high-risk strategies
  5. Put and call options: evaluating the extent to which put options lag behind call options (greed) or surpass them (fear)
  6. Safe-haven demand: comparing the returns of stocks against treasuries
  7. Stock price breadth: comparing and measuring trading volumes in rising stocks vs declining stocks

Each factor is specified on a scale of 0 to 100. The sum values of all factors are divided into seven to calculate the index. When the value of this index is 50, it is considered neutral, but when the higher values indicate greed, while values lower than 50 indicate fear.

What is the crypto fear and greed index?

The crypto fear and greed index is a similar index made by the Alternative.me website. This website believes that the crypto market behaviour is very similar to traditional markets. On the one hand, when the prices rise, people think they should buy cryptocurrencies not to miss their opportunities. On the other hand, people start to sell their crypto assets when they see a decline in prices. This index is very similar to the CNN index in which the fear shows the investors’ anxiety, even though it also offers an excellent opportunity to buy. Also, when the index shows that the investors are greedy, it could also be the time for the correction of prices.

The advantages of using the fear and greed index

Based on some scientists’ viewpoints, the impact of greediness on the human brain will force it to ignore logical thinking and decreases human self-control. Although no direct study has been done about the effects of greed on human behaviour, fear and greed are significant motivators for us when it comes to money. That is why this index has been very reliable in the market for a long time.

Most investors usually act based on their emotions. According to behavioural psychologists, there is unlimited evidence about the impacts of fear and greed on people’s decision-making process. All of them can support this index and prove that it is working correctly.

Based on many historical events, we can see how well this index works. In September 2008, the value of this index decreased to 12, which is a very low level. At the same time, the S&P500 index fell to its lowest level in a three-year period, and many large companies went bankrupt. However, this index showed the number 90 in September 2012, when the stock market was experiencing a considerable rally worldwide.

Many experts believe that the combination of the fear and greed index with other investment tools can bring investors great results. It is usually recommended to investors to monitor the index when it shows the fear in the market; because it can provide excellent opportunities to make a significant profit using leverages. It is also a good idea to go short when the index shows a high degree of greed; because the prices may fall so that you can repurchase them at a lower price.

The disadvantages of using the fear and greed index

Not all the investors like this index, and some believe it does not use a suitable strategy. They think the best strategy is buying and holding, but this index uses a market timing strategy, and such a strategy makes them leave the market frequently. Based on their approach, using the market timing strategy provides less profit for investors.

Conclusion

The fear and greed index is not flawless, but it helps investors understand the market situation better. Investors can use this index to know if it is time to buy or sell the stocks. The fear and greed index sceptics believe that this index is not a legitimate investing tool since it works based on market timing. However, they should know that understanding the market situation and acting based on it is very important. It is best not to use this index alone. Using it with other investment tools can help you achieve a better result.

FAQ

❓ How should investors control fear and greed?

✔️ Usually, the best way to control fear and greed is by making a trading plan. A trading plan helps you manage your emotions if you stick with it. The other method to decrease any emotional effect on your trading activities is to reduce the size of your trades.

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